Governments across the world have rewarded the wealthiest individuals who were to a great extent responsible for their financial debacle at state expense. There are far better uses for scarce government funds, than to underwrite excessive risk

In February 2013, the then Federal Reserve governor Jeremy Stein gave a now famous speech. In it he outlined the factors that could lead to overheating and an eventual crash. The first was a change in regulation. A change in regulation inevitably leads to the second factor, financial innovation. When confronted by a change of regulation market players, as advised by their legal talent, adapt to the new regulation by trying to find ways around it. The reason is simple. The new regulation usually prevents or adds addition costs to activities, which are profitable for market players.

This game of regulatory cat and mouse goes on all the time in every country. The exact methods to avoid the regulations vary from clever schemes to out right avoidance either legally through jurisdiction arbitrage or illegally. This game is generally not a problem unless the third factor is present. The third factor is an economic environment that encourages large risk taking. The deluge of monetary stimulus, again from almost every government, has created such an environment around the globe.

This week The Economist featured a report on shadow banking. They used the definition of the Financial Stability Board. A shadow bank is “credit intermediation involving entities and activities outside regular banking system”. In short any entity or instrument that involves a loan, provided the entity does not raise funds from depositors.

The distinction is important because governments feel that it is vital to protect one of the largest and most vulnerable parts of the financial system: depositors. Depositors in the US alone have almost $10 trillion on deposit with US banks. Most of these deposits are insured for $250,000. If a US bank goes under, which has happened 500 times in the past seven years, the depositors are guaranteed to receive at least the insured amount. There is no such guarantee for shadow or non-banks.

The list of the activities of non-banks would be long. They would include financial firms like money-market funds, asset managers, private equity, mortgage real-estate investment trusts, mortgage servicers, middle-market lending funds and clearing houses. These days they would also include large internet firms like Alibaba in China, P2P platforms, mobile payment systems of telecom companies, PayPal and the entire Chinese shadow banking system. They also would include traditional debt instruments like bonds.

The reason why these nonbanks or shadow banks are important has to do with the post crash regulations. Since the riskier behavior of the banks was considered to be a prime cause of the recession, regulators have tried to limit their exposure. They have also been required to increase their capital cushion. The result has been a slowing of lending especially to businesses.

As former governor Stein predicted the restriction of one area of lending by banks has led to enormous growth for non-banks. They have doubled in the past ten years. They make up 50% of the lending in China.

The money cascade from central banks has increased other areas. In 2007, corporate bonds issued by US corporations made up 29% of GDP. It is now 42%. It is not just the US corporations. Around the world, corporations have doubled the amount of bonds they issued between 2007 and 2012 to more than $1.7 trillion.

Asset management firm Black Rock has over $4 trillion under management dwarfing the world’s largest bank, the Industrial and Commercial Bank of China (ICBC) by a trillion dollars. Even internet firm, Alibaba, in China has collected $81 billion for its on line banking service Yu’e Bao (“leftover treasure”).

The rise of these shadow banks along with the mountain of debt they represent brings up an important question. By clipping the wings of banks, have the regulators been successful in making the financial systems safer? There are major benefits to banks. Unlike their competitors they are subject to stricter regulations everywhere they exist. Encouraging money to flow into less transparent areas of the financial world may not be the safest bet.

The argument in favour of the shadow or nonbanks is to spread the risk. If depositors are not at risk and governments do not have a legal obligation to bail these firms or their customers out, what difference does it make? If Paypal gets hacked and its users lose money, it might be a problem for Paypal and its customers, but is it really a threat to the financial system? Bonds have always defaulted. Determining which bonds are more likely to default is what rating agencies are for.

Removing risk from the parts of the financial system that the government has a legal obligation to support is an excellent goal for regulators. But there is one problem. Just because there is no legal duty does not mean that there is not a political imperative.

The US government did not have a legal duty to take over the insurance company AIG. AIG sold credit protection in the form of credit default swaps (CDSs) on collateralized debt obligations (CDOs). The amount insured amounted to a staggering $441 billion. Of those almost $60 billion were structured debt securities backed by subprime loans. When the loans went bad, AIG’s counterparties wanted the company to pay up. It couldn’t. By the middle of September 2008, it was bankrupt.

Even though AIG was not a bank and not part of the financial system, the US Federal Reserve stepped in and provided $182 billion of tax payer money. In time, AIG paid back a total of $205 billion. So the Fed made a profit, but was it worth the risk?

AIG wasn’t the only non-bank to be bailed out. The US government also bailed out broker-dealers, car-finance companies and money-market funds. The Irish almost bankrupted their government with an unnecessary unlimited guarantee of six banks. So far the Chinese government has bailed out almost every large company that has had a financial problem.

The bailouts also had the perverse effect of saving those who had taken the greatest risk. It rewarded the wealthiest individuals who were to a great extent responsible for the debacle at state expense.

Capitalism has the potential to create enormous wealth for all members of society, but there is a cost. Regulators, politicians and voters must understand that it will only work efficiently if its creative destruction is part of the process. They must understand that in a world awash in debt, a lot of it went to inefficient firms and will never be paid back. There are far better uses for scarce government funds, than to underwrite excessive risk.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)